Herbert M. Chain
Shareholder, Mayer Hoffman McCann P.C, Deputy Technical Director, Global Audit Group, Kreston Global
Herbert M. Chain is a highly experienced auditor and a financial expert with over 45 years of experience in business, accounting, and audit, having served as a Senior Audit Partner at Deloitte. He holds certifications from the National Association of Corporate Directors and the Private Directors Association, with knowledge of private company governance and effective risk management. He has extensive knowledge in the financial services sector, including asset management and insurance. Herbert sits on MHM’s Attest Methodology Group and is the Deputy Technical Director of the Kreston Global Audit Group.
PCAOB proposes replacing interim standard on substantive analytical procedures
June 17, 2024
On June 12, 2024, the U.S. PCAOB proposed replacing an interim standard on substantive analytical procedures in place since 1989 with a new standard, AS 2305, “Designing and Performing Substantive Analytical Procedures”. Public comments on the proposal are open until August 12, 2024.[1]
The proposed new standard on substantive analytical procedures
According to the PCAOB, the proposed standard covers:
- Requirements for determining whether the relationship(s) to be used in the substantive analytical procedure is sufficiently plausible and predictable;
- Requirements for dealing with differences between the auditor’s expectation and the company’s amount;
- The persuasiveness of audit evidence obtained from a substantive analytical procedure; and
- The elements of a substantive analytical procedure, including the distinction between substantive analytical procedures and other types of analytical procedures.
With this proposal and these objectives in mind, a discussion of substantive analytical procedures might be helpful, especially as technology and data analytics tools are increasingly being used to enhance the effectiveness and efficiency of audit procedures.
What are Substantive Analytical Procedures (“SAP”)?
Substantive analytical procedures (“SAP”) and tests of details are substantive audit procedures. A substantive analytical procedure, also known as substantive analytical review, is an auditing procedure used to gain assurance about the financial statements by comparing recorded amounts or ratios derived from them to expectations developed by the auditor.[2]
They are designed to address the risks of material misstatement for relevant assertions for each account and disclosure. Depending on the account, the auditor may select which substantive procedure to perform to gain such assurance. (SAPs are more effective for some accounts than other. For example, they are often more effective for income statement accounts than balance sheet accounts.)
Developing an appropriate expectation is a key aspect of an effective SAP. The development includes the uses of internal and external data, and the determination of plausible relationships. The precision of the expectation then leads to the evaluation of differences between the expectation and the recorded amount and what must be performed based thereon.
Developing a precise expectation – the key to an effective standard analytical procedure
The auditor may develop an expectation for a specific account or disclosure based on:
- Knowledge of the client: Understanding the drivers of the client’s operations (e.g., revenue streams) provides a basis for establishing plausible relationships and meaningful expectations.
- Historical Data: Comparing current figures to previous periods’ financial statements, considering known changes like growth or acquisitions.
- Industry Benchmarks: Benchmarking the client’s performance against industry averages to identify significant deviations.
- Ratio Analysis: Calculating ratios using the client’s financial data to assess relationships between accounts and identify potential inconsistencies.
- External Information: Considering relevant economic data, industry publications, or management forecasts.
- Identifying key factors: Understanding factors that significantly affect the account, like changes in pricing, production volume, or economic conditions.
- Using appropriate data level: Aggregating or disaggregating data depending on the level of detail needed for a meaningful comparison.
Data considerations
Auditors have a responsibility to ensure the underlying client data used to develop expectations is reliable, accurate, complete and relevant.
This involves considering:
- Source of Data: Is it from a reliable internal system or an external source prone to manipulation?
- Conditions of Data Gathering: Were proper controls in place to ensure data accuracy during collection?
- Auditor’s Existing Knowledge: Does the auditor have prior knowledge suggesting potential data issues?
- Understanding data gathering methods: Knowing how the data was collected and processed to ensure its accuracy and completeness
Auditors may perform additional procedures, like testing the accuracy and completeness of the data and testing the controls over financial reporting, to verify data integrity.
Analysis of results
Once the expectation has been developed, the auditor compares the recorded amount with the developed expectation. Significant differences (i.e., greater than a determined “threshold” of acceptance) require further investigation to determine if they represent a potential misstatement. Considerations may include:
- Materiality: Determine if any identified differences between recorded amounts and expectations are significant enough to potentially affect the overall financial statements.
- Plausible Explanations: Investigate potential reasons for any significant differences. These could be legitimate business developments or require further audit testing.
- Risk Assessment: Consider how the identified differences relate to the assessed risks of material misstatement in the audit.
Conclusion
Substantive analytical procedures can be a valuable tool for auditors, if designed and executed appropriately. As a substantive audit procedure, it not only addresses the risk of material misstatement, but can enhance the auditor’s knowledge of the client and its operations – but only if the expectation is precise enough, is based on reliable, accurate, complete and relevant data, and differences are appropriately analysed.
[1] Both the International Auditing and Assurance Standards Board (ISA 520) and the Auditing Standards Board of the AICPA (AU-C Section 520) also have standards addressing substantive analytical procedures
[2] This differs from analytical reviews performed as a part of the planning and overall review stages.
According to the AICPA, in the planning stage, the purpose of analytical procedures is to assist in planning the nature, timing, and extent of auditing procedures that will be used to obtain audit evidence for specific account balances or classes of transactions. In the overall review stage, the objective of analytical procedures is to assist the auditor in assessing the conclusions reached and in evaluating the overall financial statement presentation. These do not provide audit assurance as substantive audit procedures.
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